Circular on the Shariah Governance Framework for Local Banks Operating in Saudi Arabia

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In the Name of Allah, the Most Gracious, the Most Merciful Saudi Arabian Monetary Authority Headquarters

Banking Policies Department Ref: 41042498 Date: 1441/06/18 AH Attachments: 13 pages

Circular

Respected Banks, Peace, mercy, and blessings of Allah be upon you. Subject: Shariah Governance Framework for Local Banks Operating in the Kingdom.

Based on the powers vested in the Authority under its system issued by Royal Decree No. (23) dated 1377/5/23 AH, and the Banking Control System issued by Royal Decree No. (M/5) dated 1386/6/22 AH. And in light of the notable growth in financing and investment through Shariah-compliant banking products and services, as well as their relative importance to the banking sector.

We inform you that the Authority has worked on establishing a supervisory framework for banks and financial institutions practicing Islamic banking, initially manifested in the issuance of "Shariah Governance Framework for Local Banks Operating in the Kingdom," aiming to set a minimum standard for Shariah governance practices related to Islamic banking activities and to enhance the compliance environment with Shariah rulings and principles. It also specifies the roles and responsibilities of the Board of Directors, Executive Management, the Shariah Committee, Internal Audit departments, along with several other aspects regarding compliance with Shariah rulings and principles.

For your information and action, effective from 2020/8/9 AD, except for the regulatory materials referenced within the framework which have a transitional compliance period. Banks and financial institutions must also provide the Authority with an implementation plan within one month from its date.

Yours sincerely, Fahd bin Ibrahim Al-Shathri Deputy Governor for Supervision

Distribution Scope:

• Local banks and financial institutions operating in the Kingdom

P.O. Box 2992, Riyadh 11169, Telegram: MARKAZI, Fax: 4044000, Tel: 4633000, Fax: 4662414

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Shariah Governance Framework For Local Banks and Financial Institutions Operating in the Kingdom February 2020 AD

Saudi Arabian Monetary Authority

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Table of Contents

Subject	Page
Chapter One: Preliminary Provisions
Article One: Preamble	3
Article Two: Objectives of the Shariah Governance Framework	3
Article Three: Definitions	4
Chapter Two: Formation of the Shariah Governance Framework
Article Four: Formation of the Shariah Governance Framework	5
Chapter Three: Responsibilities of the Board and Executive Management
Article Five: Responsibilities of the Board	5
Article Six: Responsibilities of Executive Management	6
Chapter Four: Formation and Membership of the Shariah Committee
Article Seven: Formation of the Shariah Committee	7
Article Eight: Membership of the Shariah Committee	8
Article Nine: Meetings of the Shariah Committee	8
Chapter Five: Responsibilities and Duties of the Shariah Committee
Article Ten: Responsibilities of the Shariah Committee	9
Article Eleven: Duties and Authority of the Chairman of the Shariah Committee	9
Article Twelve: Duties and Obligations of the Members of the Shariah Committee	10
Chapter Six: Independence and Confidentiality of Information
Article Thirteen: Independence	10
Article Fourteen: Confidentiality of Information	10
Article Fifteen: Maintaining Ethics, Professional Rulings, and Consistency in Compliance with Shariah Rulings and Principles	11
Chapter Seven: Internal Control
Article Sixteen: Internal Control	11
Chapter Eight: Islamic Window Operations
Article Seventeen: Islamic Window Operations	12
Chapter Nine: Procedures for Developing Shariah-Compliant Banking Products
Article Eighteen: Procedures for Developing Shariah-Compliant Banking Products	13

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(Chapter One) Preliminary Provisions

Article One: Preamble Shariah governance has become a key requirement in the Islamic banking industry, and effective Shariah governance delivers several benefits, including:

• Mitigating the risk of non-compliance with Shariah rulings and principles.
• Supporting the stability of Islamic banking and economic growth.
• Improving operational efficiency and decision-making for Islamic banking activities and the industry.
• Attracting external investments in Shariah-compliant assets.
• Efficient management of internal capital.
• Enhancing trust among key stakeholders.
• Strengthening relationships with depositors, investors, and financiers.

For the purpose of applying effective Shariah governance requirements for banks and ensuring that Islamic banking transactions in the Kingdom align with Shariah rulings and principles, the Saudi Arabian Monetary Authority has issued this framework as a minimum standard of supervisory and regulatory requirements regarding Shariah governance practices. This is without prejudice to other regulatory bylaws and supervisory requirements issued by the Authority.

Article Two: Objectives of the Shariah Governance Framework This framework aims to enhance the compliance environment with Shariah rulings and principles across banks in general, and to specify the tasks and responsibilities of the Board of Directors, Executive Management, the Shariah Committee, Compliance Department, Risk Management Department, and Internal Audit Department regarding the application of this framework's requirements.

To achieve this, it is expected that a bank's Board and Executive Management have a reasonable understanding of Shariah principles and their broad application in Islamic finance. It is also expected that the Shariah Committee possesses sufficient knowledge of financial and banking matters in general, and Islamic finance in particular, enabling it to understand the Shariah issues presented to it. Furthermore, the Committee is expected to continuously update its knowledge on Shariah and financial matters, attend relevant training programs, and continue to enhance understanding while keeping pace with the latest developments in Islamic finance.

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Article Three: Definitions The following words and expressions, wherever they appear in this framework, carry the meanings indicated opposite them, unless the context dictates otherwise: The Authority: Saudi Arabian Monetary Authority. The Bank: Local banks and financial institutions licensed to conduct banking business in the Kingdom under the provisions of the Banking Control System, practicing Islamic banking activities. The Board: The bank's Board of Directors. Management: The bank's Executive Management and senior executives responsible for managing the bank's affairs, proposing strategic decisions, and implementing them. The Committee: A specialized Shariah committee responsible for overseeing compliance with Shariah rulings and principles and their applications in the bank. Committee Members: A group of specialists whose academic background is not limited to Islamic sciences, but also encompasses knowledge and expertise in contemporary financial transactions jurisprudence applied as Shariah rulings directed to the bank, typically not addressed to the general public or entities in other fields. Independent Committee Member: A person who enjoys full independence in position and decisions, and is not subject to any of the independence disqualifiers stipulated in Paragraph (3) of "Article Seven" of this framework. Shariah-Compliant: Adherence to the decisions issued by the bank's Shariah Committee. Islamic Window Operations: A separate part of traditional banking operations (which may be a branch or a specialized unit), providing financing and investment services compliant with Shariah rulings and principles on both the asset and liability sides. Investment Account Holders: Bank clients who hold Shariah-compliant investment accounts, which may be unrestricted or restricted based on their Shariah and accounting status. Bank Subsidiaries: Any legal entity controlled by the bank through owning more than half of its capital or voting rights, or by controlling the formation of its Board of Directors, including special purpose vehicles. Kinship:

• Fathers, mothers, grandfathers, and grandmothers.
• Sons and their children.
• Full brothers and sisters, or half-brothers and half-sisters (paternal or maternal).
• Husbands and wives. Interested Parties: Any person with an interest in the bank, such as shareholders, employees, investors, creditors, customers, suppliers, and supervisors.

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(Chapter Two) Formation of the Shariah Governance Framework

Article Four: Formation of the Shariah Governance Framework The bank must establish a Shariah governance framework focusing on key functions and elements that ensure the effective application of this framework, as follows:

1. The bank's Shariah governance framework must consist of a set of policies and procedures explaining the structure, roles, responsibilities, duties of relevant departments, and communication mechanisms among them.
2. These policies and procedures must specify the mechanism the bank should follow to apply this framework's requirements, including how committee meetings are convened, decision-making and documentation mechanisms, and reporting preparation and submission mechanisms.
3. The bank must establish formal channels for reporting between its main units/departments to ensure effective and timely reporting. In this regard, the committee's organizational linkage is to the Board.
4. The bank must establish supervisory controls to ensure that its Islamic banking activities' objectives and operations align with Shariah rulings and principles at all times.
5. The pillars forming the Shariah governance framework include: the effectiveness of the Board and Management in performing their duties, the independence and qualification of Committee members, plus the effectiveness of internal control tasks, which consist of Shariah compliance, risk management for non-compliance with Shariah rulings and principles, and internal Shariah audit.
6. Continuous evaluation of the bank's level of compliance with Shariah rulings and principles.
7. Management of potential risks arising from non-compliance with Shariah rulings and principles due to Islamic banking activities, which includes identifying inherent risks and implementing corrective measures to mitigate them.
8. Periodic and regular internal Shariah audit to verify the alignment of the bank's activities and Islamic banking operations with Shariah rulings and principles.
9. Establishment of a unit/department responsible for conducting Shariah research and studies, coordinating between Management and the Committee, distributing Shariah rulings to stakeholders within the bank, in addition to performing the Committee's secretariat duties.

(Chapter Three) Responsibilities of the Board and Executive Management

Article Five: Responsibilities of the Board

1. The Board is primarily responsible for the bank's Shariah governance framework in general and the alignment of its Islamic banking activities with Shariah rulings and principles. The Board is responsible for approving the bank's Shariah governance framework, continuously supervising its effective performance, and ensuring that the framework aligns with the bank's business volume, complexity, and nature.
2. The Board approves all of the bank's Shariah policies and supervises their effective implementation.

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3. Providing necessary mechanisms and methodologies for risk management to protect the interests of investment account holders and depositors through profit-and-loss sharing accounts.
4. Supervising the bank's compliance and implementation of Shariah decisions issued by the Committee.
5. Ensuring an effective communication policy between major banking units that facilitates and enables the escalation of important matters regarding the alignment of the bank's activities with Shariah rulings and principles.
6. Setting appropriate remuneration and salaries for Committee members based on the recommendation of the Board's Nomination and Remuneration Committee, in line with their duties and responsibilities, and consistent with relevant Authority instructions.
7. Establishing a formal procedure (based on the recommendation of the Board's Nomination and Remuneration Committee) to evaluate Committee members' performance based on a competency, knowledge, contribution, and effectiveness index.
8. Disclosing the curriculum vitae of all Committee members to enable shareholders and investors to assess their competence and ability to perform duties effectively.
9. Disclosing the mechanism followed for supervising the integrity and performance of Committee members, ensuring that no member with prior judicial conviction or a crime involving honor and trust is nominated.

Article Six: Responsibilities of Executive Management

1. Identifying Shariah issues and referring them to the Committee for a decision, providing necessary information and disclosures in a timely manner.
2. Monitoring and implementing Shariah decisions issued by the Committee.
3. Providing continuous education and training programs for key internal stakeholders, including the Board, Committee, and employees related to Shariah and financial matters, ensuring that all departments/units associated with the bank's Shariah governance framework are adequately informed about developments in Shariah-related matters.
4. Promoting a culture of compliance with Shariah rulings and principles within the bank across all its Islamic banking activities. Furthermore, it is expected that all relevant employees are familiar with the bank's Shariah-compliant products and understand the similarities and differences between Shariah-compliant banking products/services and traditional ones.
5. Ensuring the availability of Shariah policies and procedures for employees associated with applying the Shariah governance framework.
6. Ensuring that all Islamic banking operations are executed in accordance with Shariah-compliant policies and procedures, continuously reviewing and updating these policies to keep pace with market practices and developments.
7. In the event of knowledge regarding Islamic financial or banking transactions that appear to involve non-compliance with Shariah rulings and principles, the following must be done: a. Notifying the Board and Committee immediately. b. Immediately suspending the provision of any non-compliant banking services or products. c. Submitting a corrective plan approved by the Board and endorsed by the Committee to rectify non-compliant cases within (30) working days from becoming aware of them.

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(Chapter Four) Formation and Membership of the Shariah Committee

Article Seven: Formation of the Shariah Committee The Committee is formed and its members are appointed by a Board resolution based on the recommendation of the Board's Nomination Committee, after obtaining written non-objection from the Authority. The bank may obtain General Assembly approval to appoint Committee members if its internal policy so provides, with a committee membership term of three years. The Committee is formed as follows:

1. The number of members must be appropriate to the bank's business volume and nature, not less than three and not more than five.
2. The Committee Chairman must be an independent member.
3. At least two-thirds of the members must be independent. Independence is not achieved for a Committee member in the following cases: a. If he/she owns five percent or more of the bank's shares or in one of its subsidiaries. b. If he/she represents a legal entity owning five percent or more of the bank's shares or one of its subsidiaries. c. If he/she has kinship with any Board member or senior executives in the bank or one of its subsidiaries. d. If he/she serves as a Board member in one of the bank's subsidiaries for his/her Shariah Committee membership. e. If he/she works or has worked as an employee within the past two years at the bank, any counterparty, or one of its subsidiaries, as an auditor, major supplier, or owns controlling stakes in any of those parties within the past two years. f. If he/she has a direct or indirect interest in the business and contracts conducted on behalf of the bank. g. If he/she receives financial amounts from the bank in addition to his/her membership salary or allowance. h. If he/she has a credit relationship with the bank (credit cards, facilities, guarantees, etc.) in his/her name or a relative's name exceeding three hundred thousand Saudi Riyals. i. If he/she participates in a business that competes with the bank, or trades in one of the branches of activity the bank conducts. j. If he/she has served for more than six consecutive years or nine separate years in the Committee membership. k. Personal business and contracts conducted with a Committee member to meet his/her personal needs, if done under the same conditions and terms followed by the bank with general counterparties and within the bank's normal business, are not considered interests that negate independence, unless the Board's Nomination and Remuneration Committee decides otherwise. The bank must notify the Authority within (5) working days if any member loses independence for any reason.

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4. The bank must not appoint any Committee member who works in a Shariah committee of another bank operating in the Kingdom, to ensure member focus, avoid conflicts of interest, and maintain information confidentiality.
5. The bank must include a special confidentiality clause in the Committee member's appointment contract or terms, to preserve the bank's information secrecy and privacy.
6. The bank must notify the Authority in writing upon accepting a Committee member's resignation or termination for any reason within (5) working days. The resigning member must submit his/her resignation with justifications to the Board and send a copy to the Authority. Committee members' tenure cannot be terminated before its expiry without acceptable justification.

Article Eight: Membership of the Shariah Committee Committee members must be qualified to perform their assigned duties, have a clear understanding of their tasks and responsibilities, and possess the ability to exercise sound judgment objectively. Collectively, members must possess diverse professional, practical, and administrative skills, along with Shariah and financial expertise and appropriate personal attributes, particularly integrity, commitment, high reputation, competence, and responsibility. The Committee's effectiveness depends on members' experience and ability to judge comprehensively, in addition to their active participation in Committee discussions and familiarity with submitted topics before making decisions. Member qualifications should include the following attributes:

• Leadership: The member must possess leadership skills and the ability to delegate authority, leading to motivating performance for applying best practices in effective management and adhering to ethical values.
• Independence: The ability to be neutral and objective in decision-making without any influence from Management or other external parties.
• Competence: Reflected by the level of education, training, skills, and willingness to continue learning, with diverse experience of at least five years in multiple fields, including Islamic banking, compliance, and Shariah audit of financial transactions.
• Shariah and Financial Knowledge: Possessing appropriate Shariah knowledge along with the ability to read, understand, and interpret financial statements and reports.

Article Nine: Meetings of the Shariah Committee

1. The Committee holds its meetings regularly and as needed to enable effective performance, ensuring that bank operations are not affected by difficulties in obtaining Committee decisions on referred Shariah matters.
2. The Committee holds meetings periodically, not less than one meeting every three months.
3. A quorum requires the attendance of a majority of members, and decisions are issued by a majority of attending votes. In case of a tie, the Chairman's vote prevails.
4. Committee members are expected to contribute to meetings and devote sufficient time and effort to perform their duties efficiently. A member's attendance rate must not be less than (75) percent of the Committee meetings held during the financial year.

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5. Committee meetings must be documented with minutes containing discussions and deliberations, recording Committee decisions and voting results, stored in a special organized register, listing attending members' names and any reservations expressed with reasons, and signed by all attending members.

(Chapter Five) Responsibilities and Duties of the Shariah Committee

Article Ten: Responsibilities of the Shariah Committee The Committee bears responsibility for all its decisions regarding Shariah matters. The Board must rely on the Committee regarding issuing decisions on Islamic banking activities. The Committee must perform the following tasks:

1. Overseeing the alignment of the bank's Islamic banking transactions with Shariah rulings and principles. Shariah compliance reports and internal Shariah audit observations must assist the Committee in identifying matters requiring attention and proposing corrective measures when necessary.
2. Issuing decisions on Shariah matters to enable the bank to comply with Shariah rulings and principles.
3. Ensuring that policies and procedures prepared by the bank align with Shariah rulings and principles.
4. To ensure Islamic banking products comply with Shariah rulings and principles, the Committee must approve: a. The terms and conditions in forms, contracts, agreements, and other documents used to execute operations. b. The product manual, marketing advertisements, explanatory booklets, and publications used to introduce the product.
5. The Committee evaluates Compliance and Internal Shariah Audit work to ensure compliance with Shariah aspects, which forms part of its tasks when submitting reports on the evaluation of compliance with Shariah rulings and principles.
6. Interested parties at the bank, such as legal advisors, external auditors, or advisory bodies, may request the Committee's advice on Shariah matters related to bank operations, and the Committee must provide necessary assistance.
7. Notifying the Board and recommending appropriate measures to address the situation if the Committee determines that the bank has conducted non-compliant Islamic banking activities.
8. Informing the Authority of cases where non-compliant Islamic banking activities are not effectively or adequately addressed, or corrective measures are not taken regarding them.
9. Preparing an annual report on the alignment of the bank's Islamic banking activities with Shariah rulings and principles, and submitting it to the Board.

Article Eleven: Duties and Authority of the Chairman of the Shariah Committee Without prejudice to the Committee's authorities, the Chairman is responsible for leading the Committee and supervising its operations and performing his duties effectively, specifically as follows:

1. Ensuring Committee members receive complete, clear, accurate, and non-misleading information in a timely manner.
2. Verifying that the Committee effectively and promptly discusses all referred Shariah matters.
3. Encouraging Committee members to perform their duties effectively.

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Article Twelve: Duties and Obligations of the Members of the Shariah Committee

1. Attending Committee meetings and not missing them except for a valid reason, after notifying the Chairman in advance.
2. Clearly knowing his duties and responsibilities arising from Committee membership.
3. Dedicating sufficient time to review his duties, prepare for Committee meetings, and participate effectively.
4. Enabling other Committee members to freely express opinions, encouraging deliberation of topics, and seeking views from specialists in Management or others if needed.
5. Fully and promptly notifying the Board of any direct or indirect interest in business and contracts conducted on behalf of the bank, or participating directly or indirectly in any activities that may compete with the bank.
6. Not disclosing any secrets learned through his Committee membership.

(Chapter Six) Independence and Confidentiality of Information

Article Thirteen: Independence The Committee's independence must be constantly maintained in performing its duties to issue objective and reliable Shariah decisions, as follows:

1. The Board recognizes the Committee's independence and ensures it is not subject to any influence that hinders its ability to issue objective Shariah decisions when deliberating submitted matters.
2. The Committee's organizational linkage is directly to the Board.
3. Shariah decisions issued by the Committee cannot be modified or ignored without its approval.
4. The Committee must receive accurate and complete information from Management. The Committee has the right to request additional information if provided information is insufficient.
5. If required information is not provided to the Committee, the Board must be notified, and the Board must take appropriate action to rectify the situation.

Article Fourteen: Confidentiality of Information

1. Committee members are committed to maintaining the confidentiality of internal information obtained during their work and not misusing it. Confidential or sensitive information obtained by any Committee member during his work must not be used in any manner that may harm the bank.
2. Without prejudice to the above, the Committee's disclosure of information to the Authority for the purpose of informing it about the bank's serious violations of Shariah rulings and principles is not considered a breach of the confidentiality principle.

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Article Fifteen: Maintaining Ethics, Professional Rulings, and Consistency in Compliance with Shariah Rulings and Principles To ensure the quality and consistency of Shariah decisions, the Committee must adopt a formal procedure for making, documenting, approving, and maintaining Shariah decisions to ensure the reliability of the decision-making process and protect the Committee from any unjustified potential influences. In this regard, reference may be made to the procedures for developing Shariah-compliant banking products as outlined in Chapter Nine of this framework.

(Chapter Seven) Internal Control

Article Sixteen: Internal Control First: Shariah Compliance: The task of Shariah compliance is the regular evaluation of the bank's activities and Islamic banking transactions to ensure alignment with Shariah rulings and principles. Shariah compliance tasks include:

1. Ensuring the bank's level of compliance with Shariah rulings and principles, corrective procedures to address non-compliance cases, and existing supervisory mechanisms to avoid recurrence.
2. The scope of Shariah compliance tasks must cover all the bank's banking operations, including the development process of Shariah-compliant banking products, from product structuring to customer delivery as outlined in Chapter Nine of this framework.

Second: Risk Management for Non-Compliance with Shariah Rulings and Principles: Systematic management of non-compliance risks enables the bank to continue its Islamic banking operations and activities effectively without exposing itself to unacceptable risk levels. Risk management tasks include identifying, measuring, monitoring, and systematically managing non-compliance risks to mitigate potential non-compliance cases, considering the following:

1. Non-compliance risk management tasks must form part of the bank's integrated risk management framework.
2. This task must be undertaken by a responsible person with appropriate qualifications and sufficient experience, given the technical nature and complexity of non-compliance risk management.

Third: Internal Shariah Audit: The task of internal Shariah audit is an independent review process to provide objective assurance designed to add value and improve the level of compliance of the bank's activities and Islamic banking transactions with Shariah rulings and principles, aiming to ensure the soundness and effectiveness of the internal control system for compliance with Shariah rulings and principles, considering the following:

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1. Internal Shariah audit must be conducted in relatively important areas at least once a year based on the bank's risk register. Internal Shariah audit can be conducted as part of the bank's specific audit process in other specialized fields, according to risk levels and the impact ratio of non-compliance in these areas.
2. The Board's Audit Committee determines the objectives of internal Shariah audit after consulting with the Committee. Objectives must align with accepted and recognized internal audit standards.
3. Internal Shariah audit must be undertaken by internal auditors with the necessary knowledge and sufficient training in Shariah aspects. Internal auditors may utilize the bank's expert Shariah specialists in conducting audits, provided it does not affect audit objectivity.
4. Internal Shariah audit results and observations must be submitted to both the Board's Audit Committee and the Committee.

(Chapter Eight) Islamic Window Operations

Article Seventeen: Islamic Window Operations